Wednesday, October 28, 2009

Whoever would have thought that some people once called economics the most dismal of sciences? Certainly, as the current crisis goes on and on, those of us who consider ourselves to be economists scarcely are able to find the time to squeeze in a dull moment, even here and there. But even at a broader level, interest in that most dismal of dismal topics - the theory and practice of central banking - seems now to fire up levels of enthusiasm here in Spain that make even the appetising prospect of a forthcoming Real Madrid-Barça football match pale in intensity. Even if it is the case, I have to admit, that the everyday Johnny (or Jill) come lately sitting in the bar still - truth be told - prefers the sports columns of the daily newspapers, or the lacivious details of the latest romantic adventure of one of the rich and famous to a careful perusal of the detailed minutes of the last policy rate setting meeting over at the central bank.

The reason for the sudden and unexpected upsurge in interest should, I would have thought, be obvious - since with over 85% of Spanish mortgages being variable (and thus determined by the ECB policy rate), and Spain's economy sinking into an ever deeper pit, the impact of the coming decisions (or even the hints at possible future decisions) have entered peoples lives like never before. And this is doubly the case in an environment where - as Bloomberg inform us this morning - central bankers from across the global, from Washington, to Sydney, to Oslo are likely to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade, culminating in the worst financial crisis since the Great Depression.

By way of illustration for their feature story the Blomberg reporters single out the prime example cases of Norway and Australia, countries whose recent stronger than average inflation and growth performance is now so well known to regular investors for the mention of their name in such reports to have become a mere commonplace, with the respective currencies being eagery purchased to the sound of hearty lipsmaking at the thought of all the juicy carry which lies ahead. Personally though, had I been doing the writing, I would have chosen a rather different example, one much nearer to the heart of Europe (and thus a little closer to my own) - France.

And why France you may ask? Well quite simply because the French economy is now plainly and evidently on the mend. That is the big, big news which can be gleaned from last Friday's Flash Markit PMI readings.

What stands out in this PMI months data is the performance of the French economy. The output Index, based on a sample of around 85% of normal monthly survey replies, indicated that growth of the French private sector was strongly sustained in October, and into a third successive month. Climbing to 58.4, from 54.8 in September, the headline index indicated that growth accelerated markedly to reach its steepest in nearly three years.

Both the manufacturing and services sectors were strongly up - manufacturing output increased for a fourth successive month and at 55.3 (from 53.0 in September) expanded at the steepest pace since May 2006. Services activity also rose well and at a level of 57.8 put in its best performance since February 2008.

This Time France, Not Spain, Is Different, But Is It Really A Case Of Vive La Difference?

So French industrial production has been steadily recovering in recent months and the latest business surveys show this should continue, even if activity is still significantly (12%, much less than many other euro area countries) below its pre-crisis level. Consumer confidence has been steadily rising for over a year - even if, again, it continues to be weak by historic standards. Household consumption has also been rising, and in fact remained positive on an annual basis throughout the crisis (see chart below), and even if the potential for substantial further acceleration seems limited, this is still the key difference between France - where there is sufficient autonomous domestic demand left for the stimulus package to work - and the other euro area economies.

In fact this seemingly unexpected leap into poll position hardly comes as a surprise to me, since I have long been arguing that the French economy would emerge as the strongest among the EU economies from the present deep recession, and some justification for this view can be found in this post here, while an earlier piece from Claus Vistesen in 2006 also gives an illustration of how we might think about the problem.

So one epoch ends, and another begins, inauspicious as the beginnings may be. And there is both good and bad news here, since this early and isolated recovery in France is bound to create difficulties of the "exit thinking" kind for policymakers over at the ECB. The most pressing of the problems will concern what to do about containing French inflation if exit dependency in Germany means that a full recovery there remains out of reach, while Italy languishes where it has always languished and Spain's seemingly intractable difficulties only increase. In other words, what will happen if - as seems obvious - the eurozone economies are in fact diverging, and not converging, and the divergence far from reducing is in fact increasing.

The long term decline in the GDP share of French manufacturing, which is closely associated with the steady opening of a trade deficit in that country, poses special threats and problems for ECB monetary policy. This long term manufacturing decline and growing external deficit are, in my opinion, the tell tale first signs of larger structural problems to come should inappropriate monetary policy be applied too hard for too long. That is to say France is well positioned to get a distortionary bubble next time round (of the exactly the kind the newly vigilant central banks should be at pains to avoid, and indeed precisely the bubble they successfully avoided last time round) unless the ECB and the French government are very clever and very agile indeed.

Above-par Inflation Looming Just Over The Horizon

In essence the return of growth in France will be welcomed with open arms across the euro area, since with it comes the prospect of opening up a larger French current account deficit and this will, of course, clearly help soak up all that newly found need to export which exists elsewhere in Europ (and especially in the South and the East). But if this should be the fate which befalls an unsuspecting French citizenry, and living in a Spain which has already been processed along this very same pipeline, then all I can say is "heaven help them" for what will then follow.

Again, all the early warning signs are there, including the prospect that France will begin to sustain above eurozone average inflation starting next year, and this will be the first time - as can be seen in the chart below - this has really happened on any sustained basis since the euro was introduced.

In fact, if we look at the second chart, which is only the above one with the reverse overlay, we can see that French inflation really only peaked its head above the average in late 2003/early 2004, and the overshoot was not that substantial.

This time things could well be very, very different, and the big change here is of course a direct result of what has just happened to Spain. Since given that Spain has now been catapulted from a high to a low growth (or even negative growth) mode, France has been ramped up the euro league table, moving from Mr Average to Monsieur Outperform, and this will have the consequence that the ECB policy rate - which will, remember, target eurozone average inflation -will be below the one which the French economy will, in reality, need. What this will mean in practice is that there is a real danger the French inflation rate will be above the policy rate - that is that negative interest rates will be applied. As we can see in the chart below, negative interest rates were applied to the Spanish economy between early 2002 and late 2006, and we all know what happened afterwards. With the return to growth French inflation is likely to rebound, and an annual rate of headline consumer price inflation of between 1.3% and 1.5% seems not unrealistic, which means, should the ECB not start to raise its refi rate early next year then France will be rebounding strongly under the twin tailwind effect of significant fiscal stimulus AND negative interest rates.

So France is about to become the ECB's stellar pupil, but looking at what actually happened to the previous prize students (Ireland and Spain) somehow I doubt that those responsible for running things at La Banque de France and the Elysee Palace will be jumping up and down with joy at the prospect. The bottom line then is that lots of difficult decisions are now looming for European policymakers - assuming they are sharp enough to spot them at this point.

Tuesday, October 27, 2009

Friday, October 2, 2009

Eurozone unemployment is up again and, even if the pace of increase has slackened, the conventional view is that it is only a matter of time before big rises feed through. But that pessimistic take is challenged in an interesting note just published by Jacques Cailloux, European economist at Royal Bank of Scotland.

We knew much of the recent increase had been in Spain. However Cailloux makes the stunning observation that close to 60 per cent of the increase in eurozone unemployment in the current cycle has been due to the ending of short-term contracts in the Spanish construction and manufacturing sector.

He goes on to argue that Spain’s labour market may have reached a turning point, with companies’ hiring intentions improving. “The peak in euro area unemployment could thus happen earlier than we and the ECB currently expect,” he concludes.

Except maybe the ECB has spotted what is going on? Cailloux points out that back in August the ECB cited “unfavourable” labour market developments as a downside risk to growth. But last month it switched to listing better-than-expected unemployment trends as a positive, or “upside” risk. I’ve checked, and he is right.

- Since the beginning of the deterioration in euro area labour markets in March 2008, Spain has accounted for 58% of the increase in unemployment in the region

- This is 7 times the GDP weight of the Spanish economy in the euro area, underscoring how asymmetric the shock has been.

- The breakdown of the decline in Spanish employment by sectors and types of contracts shows that almost all jobs lost came from short term contracts not being renewed, mostly in the construction and industrial sectors.

- The implications for the euro area is that the outlook for unemployment is largelytied to that of Spain.

Early signs of stabilisation there mean euro area unemployment is likely to rise less than expected from here. Also, estimates of the NAIRU and of potential growth at the euro area level are likely meaningless as they are so distorted by one single country. The unemployment rate in the euro area has increased from a low of 7.2% at the beginning of 2008 to 9.6% in August this year. However, the increase in unemployment has been very uneven with countries like Spain and Ireland making a disproportionate contribution to the rise relative to the size of their economies in the region.

This notes focuses on Spain.

In less than a year and a half, the number of unemployed in Spain has risen by a staggering 2.2 millions, which is about 58% of the total increase in unemployment in the euro area: This is more than 7 times the share of Spain in euro area GDP (see chart 1)!.

The deterioration in the Spanish labour market has been unusual and far more acute than suggested by the size of the contraction in output or the build up in slack. Indeed, both chart 2 and 3 show that neither the level of growth nor the level of the output gap explains much about the Spanish labour market situation: the unemployment rate should be much lower than it currently is. Chart 2 displays the short term relationship between GDP and unemployment for a number of euro area countries. This is a graphical representation of the so called Okun’s Law. The Okun’s Law stipulates that there exists a simple statistical relationship between economic growth and the unemployment rate. More specifically, the Okun’s gap model estimation (in the economics literature) suggests that over time, the unemployment rate in the euro area rises by around 1/2 the size of the output gap in the economy. However, there are wide country differences with the coefficient estimates varying between a low of 0.1 in Italy and a high of 0.6 in Spain (see for example: BIS Working Papers, No 111, Output trends and Okun’s law, 2002).

Chart 2 shows that while on average the Okun’s coefficient is around 0.6 for the euro area and thus not too far from where you would expect it to be, wide country differences remain. In particular, Spain stands out with an increase in the unemployment rate 4 times larger than implied by the Okun’s law coefficient.

Chart 3 shows that these results are very similar when looking at GDP growth (instead of the output gap) and changes in the unemployment rate with Spain again the clear outlier.

These very surprising results could suggest that the structure of the Spanish labour market has become much more flexible than in other euro area countries or that the crisis might have pushed corporates to fire en masse, starting what might have been the long awaited and necessary adjustment to rebuild competitiveness. However, the evidence suggests otherwise with the bulk of job losses coming from the industrial and construction sectors which typically have a larger share of short term contracts rather than permanent contracts which typically have a high firing costs attached to them.

At the sectoral level, almost 80% of job losses occurred in either the construction (44%) or the industrial sector (34%). While it is little surprising that the construction and manufacturing sectors were hit hardest, given the nature of the economic crisis, the size of the adjustment has been enormous with employment down 30% in construction since the beginning of 2008 and down close to 20% in the manufacturing sector (with employment down about 12% in the car industry).

The oversized adjustment in the manufacturing and construction sectors can be explained by the fact that these sectors rely predominantly on short term contracts rather than permanent ones. These temporary contracts also have a shorter duration than in other sectors. For example, 75 percent of contracts in the construction sector have a duration of no more than 6 months (Chart 5). The breakdown of the Spanish employment data by types of contracts confirms this assessment. In fact, almost 100% of the decline in employment is due to a collapse in temporary contracts, while employment with permanent contracts hashardly fallen (Chart 6).

In all, labour market developments over the coming months will be at the centreof the ECB’s analysis on the recovery and its degree of sustainability. Thedeterioration in the labour market in this business cycle has been very unusualwith the bulk of the deterioration concentrated geographically and sectorally:close to 60% of the increase in euro area unemployment in this business cyclehas been due to the end of short term contracts in the Spanish construction andmanufacturing sectors.The implications for the euro area is mostly twofold:First, it implies that the outlook for euro area unemployment is very much tied into that of Spain. With the pace of contraction in Spanish employment easing(Chart 7), it is quite likely that the unemployment rate in the euro area has notonly past its inflection point but could actually be much closer to its peak thanmost observers including the ECB believe. The peak in euro area unemploymentcould thus happen earlier than we and the ECB currently expect. Interestingly,for the first time in this business cycle, the ECB changed its assessment onlabour markets at the September meeting by shifting labour marketsdevelopments as potential upside risks to the economic outlook from downsiderisks previously.

Second, the extent of the asymmetry in the labour market deterioration acrossthe region suggests that measures of the NAIRU and thus of potential growth atthe euro area level recently published by international organisations and marketparticipants might not be telling the right story. Indeed, the euro area aggregatesare likely heavily distorted by developments in Spain rather than by an area widephenomenon. The NAIRU in Spain has likely shot up which explains most of theincrease in the euro area NAIRU and most of the decline in euro area potentialgrowth. The decline in potential growth in countries like Germany and France islikely to have been much less pronounced by the euro area aggregates.

Growth has returned to the world economy, the International Monetary Fund announced on Thursday, but the coming recovery will be weak unless countries with large trade surpluses pick up the baton as the motors of demand.

To ensure sustained growth into the medium term, surplus countries, including China, must act to boost domestic spending and accept an appreciation of their currencies, said Olivier Blanchard, the IMF’s chief economist.

The tough IMF stance on the measures China, Germany, Japan and oil exporters needed to take to ensure a global recovery strikes a chord with US views on global trade imbalances and puts the fund on a collision course with Beijing and Berlin.

With the first upgrade in the IMF’s economic forecasts for over two years, Mr Blanchard said the twice-yearly World Economic Outlook showed “the recovery has started, financial markets are healing, and in most countries growth will be positive for the rest of the year as well as in 2010”.

The IMF forecast that world economic output would rise by 3.1 per cent next year after contracting 1.1 per cent in 2009, an upward revision of 0.6 percentage points for 2010 from its most recent forecast in July.

Emerging economies will grow much more quickly than advanced economies, the IMF says, with growth averaging 5.1 per cent in the emerging world and only 1.3 per cent in rich countries.

Although the IMF dismissed fears of a double-dip recession, it stressed that the recovery was likely to be “weak by historical standards”.

Mr Blanchard warned that the upswing would be sluggish in the months ahead because it was based on public spending and restarting companies’ mothballed production lines as unsold stock was finally shifted. “This is true of the US and most other advanced countries, but it is also true of emerging market countries,” he said.

The IMF also held out little hope that rapid growth would put world output back on the path expected before the crisis. Its latest forecast for world output is roughly 10 per cent lower than its prediction in April 2007.

For the medium term, Mr Blanchard insisted that the world needed to rebalance demand away from public support and towards the private sector; and from trade deficit countries, such as the US, towards those with trade surpluses.

“The strength of the world recovery will depend on these two rebalancing acts,” he said.

Unlike the Group of 20 leaders, the IMF did not pull its punches on the need for global currencies to shift to fostering this rebalancing. “It is very hard to see how this could happen at current exchange rates,” Mr Blanchard told a news conference.

“In gen­eral it is very hard to see how global rebal­ancing doesn’t come with an appreciation of Asian ­currencies.”

Such an aggressive stance on the need for currency realignment and demand growth in surplus countries will not be popular in Germany, Japan and China, which argue they are not to blame for producing goods others want to buy.

But Mr Blanchard expressed confidence that surplus countries’ resistance would soon fade. “I think the difference is that, this time, global rebalancing may well be needed to sustain the recovery,” he said.

About This Weblog

This blog is not a normal weblog as such, but a collection of working notes, kept for easy reference to accompany posts on Demography Matters, Global Economy Matters, A Fistful of Euros etc. Still if you are reading this,I hope you find what there is here useful. If you are looking for country specific information you might find the categories section on Demography Matters useful, or indeed anything on Global Economy Matters